Fed Likely to Pause with Potential for a Final Hike in Sight
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Fed set to hold, but signal the potential for a final hike
Mixed US data and Federal Reserve comments solidly back the market pricing of another pause at the 20 September FOMC policy meeting. However, inflation concerns linger and economic resilience suggest the Fed will continue to signal the potential for a final hike even if we don’t think it carry through with it.
Fed set to pause again on 20 September
At the last Federal Reserve monetary policy meeting in July, the Federal Open Market Committee raised the Fed funds policy rate range 25bp to 5.25-5.5%. The minutes to the decision also showed officials continue to have a bias to hike further since “most participants continued to see significant upside risks to inflation, which could require further tightening of monetary policy". At the Fed’s Jackson Hole Conference in late August Chair Powell said that policymakers “are attentive to signs that the economy may not be cooling as expected”, indicating a sense that it may indeed need to do more to ensure inflation sustainably returns to target.
Nonetheless, the FOMC minutes also suggested differences of opinion are forming. While all voting FOMC members backed the hike, there were two non-voting members who “indicated that they favoured leaving the target range for the federal funds rate unchanged”. Moreover, “a number of participants judged that… it was important that the Committee's decisions balance the risk of an inadvertent overtightening of policy against the cost of an insufficient tightening”.
In recent months we have had some encouraging news on core inflation with two consecutive 0.2% month-on-month prints with a third coming in at 0.278%, much better than the 0.4-0.5% MoM consecutive prints we got over the prior six months. There has also been evidence of moderating labour costs (the Employment Cost index and cooling average hourly earning growth) together with more modest job creation. Yet we have to acknowledge that the activity data has remained strong with the US economy on track to grow at an annualised 3% rate in the current quarter.
The commentary from officials, including the hawks, such as Neel Kashkari, suggest a willingness to pause again in September (just as it did in June), but to leave the door ajar for a further hike at either the November or December FOMC meetings.
Given this situation economists are universally expecting the Fed funds target rate range to be left at 5.25-5.5% with markets not pricing even 1bp of potential tightening. While the European Central Bank hiked rates but indicated it may be done, the Fed is set to pause, but keep its options open.
The potential for further hikes remains
As with the June hold decision, the Fed is set to suggest that the decision should be interpreted as part of its process of a slowing in the pace of rate hikes rather than an actual pause. While inflation is moderating, it is still too high and with the jobs market remaining very tight and activity holding firm, the Fed can’t take any chances.
The scenario graphic above outlines the range of possibilities outside of our core view of no change, but the door left open for future hikes. However, the other options have very low probabilities attached to them. We simply cannot see the point of the Fed softening its stance on the outlook for policy and give the markets the green light to sell the dollar and drive Treasury yields lower given this will undermine their fight against inflation. At the same time, a 25bp hike would be such a shock it could be seen as inconsistent with the Fed’s attempt to engineer a soft landing and would hurt risk appetite.
Dot plot to retain a final hike – but we don't see it being implemented
This brings us onto the updated Fed’s forecasts. The key change in June was the inclusion of an extra rate hike in their forecast for this year, which would leave the Fed funds range at 5.5-5.75% by year-end. It seems highly doubtful this will be changed given the data flow, while the unemployment and inflation numbers seem broadly on track. GDP for 2023 is likely to be revised up substantially though given the remarkable resilience of activity and the consumer spending splurge over the summer, much of which appears to have gone on leisure activities.
ING expectations for the Federal Reserve's new forecasts
